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Retirement may seem a long way off and far removed from your day-to-day concerns. And yet, this is actually the best time to start planning and saving that is, when you still have time to accumulate the money youll need.
Here are some common mistakes that throw people off course in their retirement planning. Knowing these pitfalls should help you steer clear and save more.
New Accounts With Smaller Balances
Since target-date funds can offer a lot of diversification own their own, it can be a good option for employees starting a new job. Even if youre maxing out your 401, if you have a handful of funds, the amount allocated to each might be quite small.
Depending on how much you contribute and if your employer matches, it could make sense to stay in a target-date fund for a few years while you build assets.
Rethink Your 401 Allocations
Conventional financial wisdom says that you should invest more conservatively as you get older, putting a greater amount of money into bonds and less into stocks. The reason is that if your stocks take a tumble in a prolonged bear market, you wont have as many years for their prices to recover and you may be forced to sell at a loss.
Just how conservative you should become is a matter of personal preference, but few financial advisers would recommend selling all of your stock investments and moving entirely into bonds, regardless of your age. Stocks still provide growth potential and a hedge against inflation that bonds do not. The point is that you should remain diversified in both stocks and bonds, but in an age-appropriate manner.
A conservative portfolio, for example, might consist of 70% to 75% bonds, 15% to 20% stocks, and 5% to 15% in cash or cash equivalents, such as a money-market fund. A moderately conservative one might reduce the bond portion to 55% to 60% and boost the stock portion to 35% to 40%.
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Reasons To Contribute To A 401
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If youre employed with a company that offers a 401 plan and you are not participating, reconsider! Consistently contributing to a 401 throughout your working years can help create a secure retirement.
Its not as difficult as you think: Lets say youre starting now at age 25 and your annual salary is $50,000. If you contribute ten percent of your earnings consistently, receive a three percent raise each year and earn an eight percent rate of return on your investment, you could have more than $2 million in your 401 by the time you retire at 65!1
Depending on your employers tax status, your plan may be called 403 or 457. Both are similar to a 401 in how they benefit you.
There are other financial tools available you can use to prepare for retirement, but 401s offer many advantages that other savings and investment vehicles dont. Here are three of them.
1. 401 contributions are before tax money
The amount you choose to contribute to your 401 is deducted from your paycheck before taxes are taken out. As a result, youre paying taxes on a smaller portion of your salary and your overall tax rate may be lower.
2. When you finally pay taxes on your 401, it may be at a lower rate
Do You Have A Pension Or Other Income
Target-date funds arent intended to account for your entire financial picture. If you have a sizable pension or other sources of income in retirement, consider factoring that in. In some situations, it may make sense to consider a pension as part of your fixed income allocation. Otherwise, you might be invested more conservatively than youd like.
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Fund Types Offered In 401s
Mutual funds are the most common investment options offered in 401 plans, though some are starting to offer exchange-traded funds . Both mutual funds and ETFs contain a basket of securities, such as equities. Mutual funds range from conservative to aggressive, with plenty of grades in between. Funds may be described as balanced, value, or moderate. All of the major financial firms use similar wording.
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Use Retirement Income Funds
Retirement income funds are a unique type of mutual fund. You place capital in the fund, and it is managed for you. In this case, the managers allocate your money across a diversified portfolio of stocks and bonds for you. You place a minimum amount of capital into the account, and the fund managers will do the rest, letting it grow in value. Retirement income funds are great if you prefer to have someone else manage your money and you have a few decades to let it grow.
Mistake #: Buying Too Much Of Your Companys Stock
If your employer’s stock shares are an investment choice in your 401, you may want to consider keeping your allocation to no more than 10 percent. Youre not being disloyal even the mightiest of companies think Enron and WorldCom can falter. With your salary already tied to your companys fortunes, you dont want a sizable part of your retirement savings to be similarly dependent.
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Keep Some Safe Investments
You always want to keep a portion of your retirement investments in safe backup plans. The primary goal of any safe investment is to protect what you have rather than create a high level of current income.
All retirees should have an emergency fund. This account should not be included as an asset available to produce retirement income. It is there as a safety net or something to turn to for unforeseen expenses that may come up in retirement.
Grab All The Free Cash From Your Companys Match
To get started on a tangible level, take a look at your companys 401 options, says Driscoll. Many companies offer an incentive match, encouraging you to invest part of your paycheck into a retirement fund. Whatever they match, put that percentage into your retirement fund its free money.
The incentive match is one of the best parts, maybe the single best, of the 401 plan. And the employer match is the easiest, safest money you could ever make, offering you an immediate return for doing what you need to do anyway.
Many employers will match 50 percent of your contribution and sometimes as much as 100 percent up to a certain amount. A few employers do even better than that, although many employers do not offer a match at all.
Ensure you have contributed enough to get the full company match, says Kirk Kinder, certified financial planner at Picket Fence Financial in Bel Air, Maryland. There isnt any legit reason not to get the full match.
Starting Late Turn Up The Dial On Your Contributions
Making the most of the early years of your career is one way to hit your retirement savings goaland probably the easiestbut it’s not the only way. If you have less time to save for retirement, you’ll simply need to save more each year.
For example, as we saw above, if your goal is to have $1 million at age 65 and you save just under $4,500 each year starting at age 20, there’s a good chance you’d meet your goal.
If you start at age 30 instead, you’ll have to save about $9,000 each year for the same chance at reaching your goal.
Beginning at age 40? You’ll need to save about $18,000 a year. And if you wait until age 50, you’ll need to put away over $40,000 a year to give yourself a good shot at reaching your goal.*
In other words, no matter what your current age, you’ll always be better off starting now rather than waiting until later.
Avoid Choosing Funds With High Fees
It costs money to run a 401 plan. The fees generally come out of your investment returns. Consider the following example posted by the Department of Labor.
Say you start with a 401 balance of $25,000 that generates a 7% average annual return over the next 35 years. If you pay 0.5% in annual fees and expenses, your account will grow to $227,000. However, increase the fees and expenses to 1.5%, and you’ll end up with only $163,000effectively handing over an additional $64,000 to pay administrators and investment companies.
You can’t avoid all of the fees and costs associated with your 401 plan. They are determined by the deal your employer made with the financial services company that manages the plan. The Department of Labor has rules that require workers to be given information on fees and charges to make informed investment decisions.
The business of running your 401 generates two sets of billsplan expenses, which you cannot avoid, and fund fees, which hinge on the investments you choose. The former pays for the administrative work of tending to the retirement plan itself, including keeping track of contributions and participants. The latter includes everything from trading commissions to paying portfolio managers’ salaries to pull the levers and make decisions.
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You Could Retire Early
First of all, were going to say that the risks here are massive. Investing always comes with a risk, and digital currencies are no different. They could pose an even greater risk than other standard retirement plans. But, if youre serious about making BTC or any other digital currency your retirement plan could come with a massive upside. First of all, cryptocurrencies are highly volatile, which is a trait that still is their main benchmark. While this means their price can go up or fall at any given moment, it also means that with a proper approach you can make use of it.
The Popularityand Costof Convenience
According to a recent Vanguard study, 77% of retirement plan participants were using at least one target-date fund. Age-based options are popular for several reasons. First, its a turnkey solution for investors who arent comfortable creating their own asset allocation. The fund manages all the rebalancing, so the investor can be hands-off.
Another reason for the rise in target-date funds isnt about choice at all. Age-based funds are commonly the default investment option in 401 plans. Many busy executives never get around to considering a change.
Convenience doesnt come without a cost, however. Morningstar reports that although costs have been declining, the average expense ratio for a target-date mutual fund is .62%. The expense ratio on an investment is essentially the price you pay the fund company to invest in that particular product. These costs eat into your return, so its an important factor when picking investments.
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You Cant Predict Your Future Tax Rate
Another crucial issue with 401ks is that you cant know what your tax rate will be at age 59.5, or for that matter, at age 70, 80, 90 or 100. This puts a quite a wrench into the tax-deferred argument, whereby some people suggest that its better to defer income taxes into the future.
First, as mentioned earlier, 401k withdrawals get taxed as ordinary income, and are therefore, subject to state and federal taxes. State taxes can go as high as 13.3% and federal tax rates start at 10% and can go as high as 37%. Unfortunately, the investment gain portion of your 401k wont get separated out and treated as a long-term capital gain, which it would if your investments werent held within a 401k and were owned for at least 12 months. Long-term capital gain tax rates only range from 0 to 20%.
Also, I think itd be a rare person whose income tax rate would be lower in retirement than in their 20s when they most likely had minimal work skills and experience.
Then, of course, we have no idea what the tax rates will be in the future and they certainly could be raised. This has happened before. For example, the highest U.S. income tax rate jumped from 15% in 1916 to 67% in 1917 to 77% in 1918. You know, war is expensive.
Finally, the 401k only allows for small tax savings up front when you are young or middle-aged, but this is when youre most likely to have the best tax write-offs relative to your income.
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Mistake #: Getting Out Of The Market After A Downturn
When the market takes a big hit, you may be tempted to pull out all the stocks in your retirement portfolio. If you do, youll miss the gains if the market turns around. You want to keep a good mix of asset classes in your portfolio: stocks, bonds, and cash. And once a year, you should rebalance to keep your asset allocation on track.
The Amazing Power Of Beginning Early
Who wants to be a millionaire?
For many people, having a million dollars might seem like being elected Presidenta worthy but unattainable goal.
But getting to a million might not be that hard if you know the secret: time.
If you give your savings enough time to grow, you’ll only need relatively small investments of moneymade consistentlyto wind up with a pretty big balance.
How much do you think you’d need to save each year in order to reach a goal of a million dollars? $20,000? $50,000?
In fact, if you save just under $4,500 per year over a 45-year career, you could have over $1 million by the time you retire. And if you have the opportunity to invest in a retirement plan that offers a matching contribution from your employer, your yearly investment could be as small as $2,200.
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Think About Opening A Roth 401
If youre looking ahead a few years, you may also want to consider opening a specific type of 401 called a Roth 401. With the Roth version, you fund with after-tax money, but youre able to enjoy tax-free withdrawals at retirement. .)
Tax rates are relatively low, so now could be a good time to fund a Roth 401 rather than a traditional 401.
With the Trump tax law due to sunset in 2025, we are facing higher rates in the future, says Kinder. It could be an excellent time to utilize the Roth 401 option and take advantage of the lower rates now. This is especially true for folks under 40 or folks in the 10 percent or 12 percent tax bracket.
Lower tax rates mean that the cost to take advantage of the Roth plan is lower, since you fund it with after-tax money. Taxpayers in higher brackets may find their break on current taxes is more advantageous, however, and stick to the traditional 401 plan.
This Bankrate calculator can help you decide whether the traditional 401 or Roth 401 is better for you.
The One Thing Guaranteed To Increase The Return On Your 401
If its not obvious yet, the key factor in dragging down the average 401 return is fees. Most 401 plans are chock full of fees, and that does one thing it takes money away from you and puts it in someone elses pocket.
Unfortunately, few believe 401 plans actually charge fees as a recent study shows that 67 percent of individuals dont believe there are fees in their 401 plan. Thats the same as thinking a car can drive without a motor.
- Investment fees
- Individual services fees
The fees dont stop there. Depending on the mutual fund you choose in your 401 plan you could also be paying the following fees:
- Sales charges
- Management fees
- 12b-1 fees
- More, depending on the fund of choice
When totalled, these fees can easily equate to an additional 1-2% in charges. Those directly impact your return, to the tune of tens of thousands of dollars over your career, thanks to losses in compound interest.
In fact, that one percent difference can mean adding a decade to your retirement income.
Should we give in and assume theres no way to cut down on these bloodsucking fees? No, there are ways to find lower fee options that will keep more money in your portfolio and, better yet, its not that difficult to find those cheaper alternatives.
The best tool to find those alternatives is Personal Capital. Personal Capital is a free to use service that helps you better manage your finances.
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